This Indicator Helps Identify Volatility “Squeezes” Before A Price Breakout
There are only a few technical indicators that measure volatility. Most indicators use price and attempt to identify trend changes.
Bollinger Bandwidth measures how strong the recent trend is.
It does not offer any information about whether prices will go up or down in the future. Instead, the indicator highlights periods of high or low volatility.
What Is Bollinger Bandwidth?
This technical indicator measures the distance between the upper and lower Bollinger Bands. The Bands contract and expand with volatility.
Volatility tends to move in a cyclical pattern, and big price moves often follow periods of low volatility. Bollinger Bandwidth quantifies the volatility and you can add it to a chart to help you spot when big price moves are likely to occur.
Bollinger Bandwidth is calculated by taking the difference between the upper Band and the lower Band. Then divide that difference by the moving average of the closing prices (i.e., the middle Band).
The indicator gives readings that can be compared on a relative basis to prior trading history (this is where a moving average of the Bollinger Bandwidth can be helpful). Low values correspond to low volatility and high values corresponding to high volatility. It can be used in any time frame.
How Traders Use Bollinger Bandwidth
Bollinger Bands and Bandwidth were developed by market analyst John Bollinger. He details a strategy that he calls “The Squeeze” as a trading setup that uses Bandwidth.
Bollinger Bands expand and contract with the price action. Increased volatility drives an expansion in the Bands and lower volatility squeezes the Bands together. As a measure of the distance between the Bands, Bandwidth shows these changes in volatility as a single, easy-to-use indicator. A low-volatility squeeze is a signal that a volatile period is likely to begin soon. This means a price breakout is likely to occur.
Using Bandwidth, a squeeze is represented by a low value of the indicator. Some traders like to see a 125-day low in the value of the Bollinger Bandwidth as an indicator for a squeeze set-up. Traders then use other indicators to confirm the direction of the expected price breakout.
A squeeze only indicates that a big move is likely to occur; it does not forecast direction. You can see this in the example below. One squeeze signaled a price decline, another delivered a false signal, and the third one came before a price gain.
Momentum indicators, like Moving Average Convergence/Divergence (MACD), can be useful in forecasting the direction of the breakout. Traders could use other momentum or trend-following indicators to determine how to trade the squeeze.
Why Bollinger Bandwidth Matters To Traders
Traders generally prefer high volatility because fast price moves can result in fast profits. Watching for a squeeze setup will help the trader get into potentially volatile trades early.
As stated earlier, traders have very few tools to evaluate volatility on individual securities. Bollinger Bandwidth is one of them. This makes it valuable, because it’s of the rare tools that offer clear and frequently timely signals.
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